Chapter 1: Introduction

It is only by risking our persons from one hour to another that

we live at all.
William James
The Will to Believe, 1897

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 1

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Important Concepts in Chapter 1

Different types of derivatives

Risk preferences, risk-return tradeoff, and market
efficiency
Theoretical fair value
Arbitrage, storage, and delivery
The role of derivative markets
Criticisms of derivatives

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 2

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Business risk vs. financial risk

Derivatives
A derivative is a financial instrument whose return is
derived from the return on another instrument.
Size of the OTC derivatives market at year-end 2007
$596 trillion notional principal
GDP is only $15 trillion
Real vs. financial assets

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 3

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivative Markets and Instruments

Options
Definition: a contract between two parties that gives
one party, the buyer, the right to buy or sell something
from or to the other party, the seller, at a later date at a
price agreed upon today
Option terminology
price/premium
call/put
exchange-listed vs. over-the-counter options

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 4

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivative Markets and Instruments

(continued)

Forward Contracts
Definition: a contract between two parties for one
party to buy something from the other at a later date at
a price agreed upon today
Exclusively over-the-counter

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 5

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivative Markets and Instruments

(continued)

Futures Contracts
Definition: a contract between two parties for one
party to buy something from the other at a later date at
a price agreed upon today; subject to a daily settlement
of gains and losses and guaranteed against the risk that
either party might default
Exclusively traded on a futures exchange

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 6

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivative Markets and Instruments

(continued)

Options on Futures (also known as commodity options or

futures options)
Definition: a contract between two parties giving one
party the right to buy or sell a futures contract from the
other at a later date at a price agreed upon today
Exclusively traded on a futures exchange

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 7

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivative Markets and Instruments

(continued)

Swaps and Other Derivatives

Definition of a swap: a contract in which two parties
agree to exchange a series of cash flows
Exclusively over-the-counter
Other types of derivatives include swaptions and
hybrids. Their creation is a process called financial
engineering.
The Underlying Asset
Called the underlying
A derivative derives its value from the underlying.

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 8

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Some Important Concepts in Financial and

Derivative Markets

Risk Preference
Risk aversion vs. risk neutrality
Risk premium
Short Selling
Repurchase agreements (repos)
Return and Risk
Risk defined
The risk-return tradeoff (see Figure 1.1)

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 9

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Some Important Concepts in Financial and

Derivative Markets (continued)

Market Efficiency and Theoretical Fair Value

Efficient market defined: A market in which the price of
an asset equals its true economic value.
An efficient market is a consequence of rational and
knowledgeable investor behavior
The concept of theoretical fair value
The true economic value

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 10

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Fundamental Linkages Between Spot and

Derivative Markets

Arbitrage and the Law of One Price

Arbitrage defined: A type of profit-seeking transaction
where the same good trades at two prices.
Example: See Figure 1.2
The concept of states of the world
The Law of One Price
The Storage Mechanism: Spreading Consumption across
Time
Delivery and Settlement

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 11

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Role of Derivative Markets

Risk Management
Hedging vs. speculation
Setting risk to an acceptable level
Example: Southwest Airlines
Price Discovery
Operational Advantages
Transaction costs
Liquidity
Ease of short selling
Market Efficiency

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 12

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Criticisms of Derivative Markets

Speculation
Comparison to gambling

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 13

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Misuses of Derivatives

High leverage
Inappropriate use

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 14

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Derivatives and Your Career

Financial management in a business

Small businesses ownership
Investment management
Public service

Source of Information on Derivatives

http://www.cengage.com/finance/chance

Summary
Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 15

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

(Return to text slide)

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 16

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

(Return to text slide)

Chance/Brooks

An Introduction to Derivatives and Risk Management, 8th ed.

Ch. 1: 17

2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.